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The Good Times Are Over for Japan’s Loot-Box-Style Gaming Bonanza

(Bloomberg Businessweek) -- Getting players to pay real-world money for digital items has become de rigueur for most mobile game makers, but in Japan it’s something like an art. Over the past decade, fighting and puzzle games with titles such as Monster Strike and Puzzle & Dragons haven’t just made Candy Crush Saga look like a piker—they’ve ranked among the most lucrative digital products on Earth. The creators of Monster Strike and Puzzle & Dragons, Mixi Inc. and GungHo Online Entertainment Inc., respectively, are among the game makers specializing in gacha, a form of not-quite-gambling in which players pay for a mystery in-game prize, typically a special weapon or character outfit. Japanese gacha games have generated at least $55 billion since 2007, according to industry association Mobile Content Forum (MCF) and an analysis of data compiled by Bloomberg.

Yet for Japan’s pioneers of mobile gaming—or, according to critics, gambling—the good times seem to be just about over. Mostly unable to produce follow-up hits, the companies are losing market share to more innovative rivals in China and South Korea, and their profits and share prices are tumbling. “The gacha business model is under pressure to change,” says Koki Kimura, president of Mixi, whose stock has crashed 65 percent from last year’s all-time peak. He predicts mobile games, which account for 90 percent of Mixi’s $1.7 billion in annual revenue, will drop to a third of the total in 5 to 10 years, supplanted by sports broadcasting and gyms.

Mixi’s Japanese rivals are changing the makeup of their businesses as well. DeNA Co., best known in the U.S. for its work on Super Mario Run, is shifting engineers to develop autonomous-driving software. Gree Inc., another early gacha maker, invested $90 million in April to create a quasi-talent agency for turning digital avatars into popular YouTube personalities; it expects the agency to drive earnings within three years. CyberAgent, Colopl, and Line are embracing online TV, virtual reality, and cryptocurrencies. “Most domestic mobile game operators now want to look outside of games,” says Takao Suzuki, an analyst at Daiwa Securities Group Inc.

Suzuki and other analysts are struggling to grasp how the local industry could give up on the giant profit engine it created. DeNA became the first game maker to incorporate gacha, named for the sound Japan’s vending machines make when dispensing toys, in 2006. Since then, its portfolio of gacha games has generated $9.5 billion in revenue, according to data compiled by Bloomberg. The in-game purchases proved so profitable for DeNA, previously an online auction site operator, that other companies without any games experience quickly followed suit, says Serkan Toto, who runs consulting firm Kantan Games Inc.

Regulators eventually set limits on certain gacha features deemed overly addictive, but those 2012 reforms didn’t slow the industry. “It was really like paradise,” Toto says. Smartphones increased spending with better graphics and payment methods, boosting gacha revenue from $430 million in 2011 to $13 billion last year, according to MCF. Mixi’s Monster Strike alone has pulled in $7.1 billion since 2013, making it the most profitable smartphone app in history, according to Sensor Tower. GungHo’s Puzzle & Dragons has taken in $6.9 billion since 2012. (Compare that with $4.6 billion for Candy Crush Saga or $1.2 billion for Tinder.)

The problem? “They didn’t invest in their employees,” Suzuki says. Instead of using their cash hoards to make better games, the early leaders settled for licensing famous characters such as Batman and Luke Skywalker to appear in their games or for making their gacha collections more sexually suggestive. Japanese companies spend an average of $7 million to develop a single big-name mobile game, Suzuki estimates, compared with $18 million a game among competitors in China. “There’s just not enough innovation,” says Masaru Sugiyama, an analyst with Goldman Sachs Group Inc.

The difference is showing. Knives Out, a fighting game made by China’s NetEase Inc., has consistently ranked among Japan’s top five mobile apps this year, earning as much as $65 million a month, according to brokerage China Renaissance Holdings Ltd. South Korea’s Netmarble Corp. has won over many of Japan’s biggest spenders, including its most famous day trader, who goes by CIS on Twitter and in June bragged about spending roughly half a million dollars to unlock a rare character in the company’s Lineage II. Meanwhile, combined operating profit from games at Japan’s seven largest mobile publishers fell 21 percent in the latest fiscal year, to $1.4 billion, and the companies’ stocks have cumulatively lost $6 billion in market value since January. “Japan’s entire mobile game market as a whole is still growing,” Sugiyama says. “But the share that goes to Japanese companies is falling.”

The Japanese companies’ moves away from games have been bumpy. DeNA had to shut its online publishing business last year after several blogs posted dubious health advice and plagiarized material. Mixi closed its ticketing site this year after a police investigation found the company resold tickets without authorization, and Kimura’s predecessor resigned. The companies have said their efforts to shift business models are still in their early stages, and Kimura predicts that the industry will consolidate further to cope with falling profits.

In any case, gacha’s legacy of squeezing gamers for money, in ways that parents and consumer advocates complain are basically gambling, will live on. In the West, the real-money-for-mystery-prizes concept has been rebranded as the “loot box,” a central moneymaker in top-shelf hits from Fortnite to FIFA 19. Goldman Sachs estimates that loot boxes will generate half the global video game industry’s $120 billion in revenue this year. But the real lesson game makers should take from the gacha pioneers is a cautionary one, says Sugiyama: Don’t discount creativity.